Sheesh... it's about time.
Finally, someone is writing about how bad the "bailout" of LTCM (a hedge fund) was as a precedent to the current financial crisis. Tyler Cowen of Marginal Revolution fame writes in the NYT:
If regulators had been less concerned with protecting [Long Term Capital Management's] creditors, our current problems might not be quite so bad.
Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.
Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New Yorkorganized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.
At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.
And really, thus began the notion of "too big to fail."
The major creditors of the fund included Bear Stearns, Merrill Lynchand Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.
I think this is so very important. Not only did we set the worst kind of precedent possible - giving the financial industry a false sense that government would intervene in cases of catastrophic losses, somehow the Fed and Greenspan took no lesson away from the near disaster that was LTCM, namely, that it might not be in the country's (or even the world's) best economic interest to allow institutions to be so highly levered that their distress could cause systemic failure. There was no attempt, after LTCM, to cap the amount of leverage allowed to a non-bank financial company. Rather, the entire attitude was like, crisis averted, let the party continue! The article continues:
In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.
The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. Decisions are made as to whether a merger is possible, whether a consortium can be organized, what kind of loan guarantees can be offered and what kind of concessions will be extracted in return. So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.
Of course, no discussion of LTCM would be complete w/o a shout-out to the book that made me interested in all of this finance stuff, the extrodinary When Genius Failed: The Rise and Fall of Long Term Capital Management. One of the most compelling and page turning finance books out there.
Comments